of individual banks (microprudential supervision). Even before the global financial crisis, there were moves to separate these functions (for example, the British government took banking supervision away from the Bank of England in 1997 and gave it to the newly created Financial Services Authority), and in the aftermath of the crisis there has been intense discussion among politicians and bank regulators about how these roles should be assigned. Views differ on how to divide the responsibilities, and no clear consensus has formed on the right way to do it.
The body that is given responsibility for microprudential supervision usually has responsibility not only for bank regulation but also for bank supervision. Regulation refers to the process of writing rules that govern how banks operate and behave (for example, setting minimum levels of capital, or requiring banks to set aside a proportion of their deposits as a reserve) whereas supervision refers to the enforcement of those rules (for example, by examining a bank's financial statements or sending inspectors to speak to a bank's management).
Examples of central banks include the Central Bank of Bahrain, the Bank of Japan, the People's Bank of China, and the Federal Reserve System.
INTEREST RATES AND INFLATION RATES
An interest rate is the price of credit, or the rate a lender charges a borrower for using borrowed funds. The inflation rate is the change in the purchasing value of money.
Bank B lends EUR 1,000,000 to Compagnie Petit, a French corporation, for one year. In exchange for the corporation using these funds, the bank charges 6 % interest rate per year. At the end of the year, Compagnie Petit must pay EUR 60,000 in interest to the bank as well as repay the original EUR 1,000,000.
At the beginning of the year, Jean Molineaux paid EUR 100 for various groceries at the store. At the end of the year, the same groceries at the same store cost EUR 105. Since the price of the same groceries increased by 5 % during the year, the purchasing power of the money declined by approximately 5 %. This decline in purchasing power is the inflation rate.
There are multiple definitions of risk. Everyone has a definition of what risk is, and everyone recognizes a wide range of risks. Some of the more widely discussed definitions of risk include the following:
• The likelihood an undesirable event will occur
• The magnitude of loss from an unexpected event
• The probability that “things won't go well”
• The effects of an adverse outcome
Banks face several types of risk. All the following are examples of the various risks banks encounter:
• Borrowers may submit loan repayments late or fail to make repayments.
• Depositors may demand the return of their money at a faster rate than the bank has reserved for.
• Market interest rates may change and hurt the value of a bank's loans.
• Investments made by the bank in securities or private companies may lose value.
• A bank may discover that it has acted in a way that is contrary to a law or regulation and be fined by its regulator or by a court of law.
• Human input errors or fraud in computer systems can lead to losses.
To monitor, manage, and measure these risks, banks are actively engaged in risk management. In a bank, the risk management function contributes to the management of the risks a bank faces by continuously measuring the risk of its current portfolio of assets and other exposures; by communicating the risk profile of the bank to others within the bank, to the bank's regulators, and to other relevant parties; and by taking steps either directly or in collaboration with other bank functions to reduce the possibility of loss or to mitigate the size of the potential loss.
From a regulatory perspective, the size and risk of a bank's assets are the most important determinants of how much regulatory reserve capital the bank is required to hold. A bank with high-risk assets faces the possibility that those assets could quickly lose value. If the market – depositors – perceives that the bank is unstable and deposits are in peril, then nervous depositors may withdraw their funds from the bank. If too many depositors want to withdraw their funds at the same time, then fear that the bank will run out of money could break out (Section 3.1 discusses how bank runs occur). And when there is a widespread withdrawal of money from a bank, the bank may be forced to sell its assets under pressure. To avoid this, regulators want a bank with high-risk assets to have more reserves available. Therefore, understanding banking regulation requires understanding financial risk management.
This section introduces the various types of risk a bank may face and provides examples that demonstrate each risk. Later chapters explore these risks and their regulatory implications in more detail. The key risks discussed below are those identified by the Basel Accords, the cornerstone of international risk-based banking regulation. The Basel Accords, described in greater detail in Section 3.3 and throughout the book, are the result of a collaborative attempt by banking regulators from major developed countries to create a globally valid and widely applicable framework for banks and bank risk management.
The Basel III Accord, the most recent of these accords, focuses primarily on four types of risk (see Figure 1.4):
1. Credit risk
2. Market risk
3. Operational risk
4. Liquidity risk
Figure 1.4 Bank Risks
The Basel Accords also recognize that there are other types of risk that may include these different core risk types.
1.3.1 Credit Risk
Credit risk is the risk that a bank borrower, also known as a counterparty, may fail to meet its obligations – pay interest on the loan and repay the amount borrowed – in accordance with agreed terms. Credit risk is the largest risk most banks face and arises from the possibility that loans or bonds held by a bank will not be repaid either partially or fully. Credit risk is often synonymous with default risk.
EXAMPLE
In December 2007, the large Swiss bank UBS announced a loss of USD 10 billion due to the significant loss in value of loans made to high-risk borrowers (subprime mortgage borrowers). Many high-risk borrowers could not repay their loans, and the complex models used by UBS to predict the likelihood of credit losses turned out to be incorrect. Other major banks all over the world suffered similar losses due to incorrectly assessing the likelihood of default on mortgage payments. The inability to assess or respond correctly to this risk resulted in many billions of U.S. dollars in losses to companies and individuals around the world.
Credit risk affects depositors as well. From the depositors' perspective, credit risk is the risk that the bank will not be able to repay funds when they ask for them.
The underwriting process aims to assess the credit risk associated with lending to a particular potential borrower. Chapter 4 contains a detailed description of the underwriting process. Once a loan is underwritten and the loan is received by the customer, the loan becomes a part of the bank's banking book. The banking book is the portfolio of assets (primarily loans) the bank holds, does not actively
